Income splitting reduces income taxes by transferring the income of a person in a higher marginal tax bracket to a person in a lower marginal tax bracket. The income splitting strategy is typically employed within a family, in order to lower the aggregate income tax paid by the family as a group. For example, a parent who earns enough to be in a high tax bracket employs his daughter, who is in a low tax bracket. The payments made to the daughter are a business expense to the parent, thereby reducing his net taxable income. The payments made to the daughter are taxed at her much lower marginal tax bracket. This approach is also effective for shifting taxable income between spouses, if they are filing tax returns separately and there is a large income gap between them.
The income splitting concept can also be applied to tax credits. For example, the tuition credits available to a student can be shifted to a higher-income parent when the parent funds the college education of the student.
Income splitting does not work when all family members are subject to the same marginal tax rate.